The Morality of Fractional Reserve Banking

One of Murray Rothbard's strangest doctrines is that fractional reserve banking (i.e. virtually all banking with which First World consumers have any direct experience) is inherently fraudulent and should therefore be illegal. As he puts it in The Mystery of Banking:

It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.

No
administrator is needed to prevent nonfraudulent sales; if a man simply
sells what he calls "bread," it must meet the common
definition of bread held by consumers, and not some arbitrary
specification. However, if he specifies the
composition on the loaf, he is liable for prosecution if he is lying.
It must be emphasized that the crime is not lying per se,
which is a moral problem not under the province of a free-market
defense agency, but breaching a contract--taking
someone else's property under false pretenses and therefore
being guilty of fraud.

If "the bank can lend out your money to other people" is not part of the "common definition" of a bank account, what is? This is especially clear if you remember that most banks do offer a 100% reserve option - called safety deposit boxes. So if Rothbard asked the typical bank customer to explain the difference between a bank account and a safety deposit box, what on earth would he expect him to say?

In the end, Rothbard's position is as absurd as claiming that it's fraudulent to sell non-organic bread. Not only do grocers sell organic and non-organic bread side-by-side; non-organic bread is still a lot more popular!

Comments and Sharing

Bryan, I have not read MR but I'm sure that, as other Austrians, he was referring ONLY to demand deposits. Milton Friedman also argued for 100% reserve requirement on demand deposits, not on savings and time deposits. In Argentina, Peron imposed 100% reserve requirement on ALL deposits because he wanted to control the allocation of loanable funds.

Rothbard's definition of fraud (as presented here) is dependent upon the misrepresentation of the seller -- not the perception of the buyer. Whether central banking is fraudulent or not would depend upon what the banks say vs. what they actually do. Since banks are obligated to pay depositors upon demand, but are incapable of reimbursing at any moment even a tenth of their depositors, they are (in Rothbard's opinion) selling something that they do not have.

I'm afraid semantics will not sink this ship; if you want to argue Rothbard's point, you will have to get your hands dirty.

Banks traditionally include clauses in their depositor contracts that give them the right to cease all withdrawals for a specified period. Most "demand deposits" are really no such thing; it is just good customer service, not a legal requirement, for the bank to repay depositors on demand. The clause is a precaution in case there is difficulty obtaining the funds; sometimes the bank is required to pay additional interest while the depositor waits. Chequing accounts are "as good as cash" because satisfying withdrawals immediately is not actually that difficult. If banks frequently invoked their right to suspend withdrawals, then chequing accounts would no longer be "as good as cash."

As for the general issue that the bank might fail to satisfy its debts in some circumstances, so what? That is the case of all debts. The presence of interest (or absence of storage fees) should tip depositors off that the benefits of banking come with some risk, however small. It is possible that an insurance company might fail to meet all its obligations to policy holders, but such a possibility does not make the insurers promises worthless or fraudulent.

In any case, the bank does not lend out your money, because whatever is deposited in the bank becomes the full property of the bank. The depositor owns bank IOUs. This is an exchange of one type of money for another. It's not like the bank is lending your money, because the IOUs are your money.

"Banking" differs from "storage" thanks in large part to fractional reserves. The safe deposit box is a good example of 100% reserves... I imagine banks could make money setting up lines of credit secured by the contents of Rothbardians' safe deposit boxes, and everyone should be happy. Unless, of course, the Rothbardians think they shouldn't have to pay for storage and liquidity.

from my time spent on the mises forums and the writings I've been referred to it seems that austrians don't understand the idea of future obligations denoted in today's dollars. FRB isn't the only place they run into conceptual difficulties with this but with many types of financial transactions.

This has always seemed clear enough to me, provided that the contractual terms are clear and that defaulted demand obligation are remediable through tort. A more interesting question is: what is the deep (Rothbardian) objection to a classic Ponzi scheme, where early entrants can and do benefit? Are participant's in such exchanges presumed to be incapable of projecting inherent risk?

As long as fractional reserve banking is voluntary and contractual, I don't think it's fraud. If a bank says that they will pay x% interest rate, but they will only keep 20% of deposits on site, that is a choice the consumer would have to make.

Under Free Banking, I would expect competition to push the reserve ratio high, but not to 100%. If the reserve ratio were 80%, for example, there's really zero chance that the depositor will be unable to get his money out.

It's all about the risk of a run. If you want the benefits of fractional reserve banking, then you have to accept some risk of not getting all your money on demand during a run.

Unless, of course, the bankers have really good lobbyists and can convince the government to assume the liability in the worst case.

At one extreme there is "abject fraud", at the other "safe deposit boxes". Fractional banking lies somewhere between these extremes, and how the risk is handled (and who assumes the risk) fine tunes the issue even more.

This is what I've argued with Rothbardians before too. I don't know of anyone who doesn't know that if they deposit their money in a bank in an account that makes interest, the bank is going to use that money to make loans. Most people I know mistakenly assume that that is where the modern bank gets all of its money to loan out.

Calling "modern fractional reserve banking" a fraud is not the same thing as saying that depositor-bank contracts are fraudulent. When a system becomes national policy and is codified into law, and the risks are subsumed by government, there is no contract and "fraud" must take on a different meaning. What that might be, I haven't a clue. I suspect Rothbard meant it in a descriptive rather than legal sense. But frankly I could care less and whom do these word games benefit?

Kelly - it is not a question of whats risks you run. It is the question of whether the risks and the benefits accrue to the same individuals. Modern FRB is a state entity, and the liabilities rest upon the currency and ultimately the taxpayers. Bailouts are an obvious example but inflationary policy, deteriorating reserve standards, deposit insurance and accounting games accomplish much the same thing. We have instituted a system that by its nature is highly leveraged and loaded with risk; we have met each crisis by leveraging ourselves further; and we have done everything in our power to make the accumulated risk systemic rather than individual. I suppose that whether the cost-benefit of this system appeals to you, depends upon how old you are, and whether or not you have children.

Chip - to the extent that ponzi schemes are fraud, I suspect that Rothbard objected to them on that basis. He seems to have reserved most of his ire for pyramids that are foisted upon the general public, where the participants' capability of "projecting inherent risk" is moot. What I find interesting isn't so much hypotheticals about Rothbardians, but rather the spectacle of Greek youth asking en masse why they should pay for their parents' and grandparents' mistakes - and then paying anyway.

Rothbard obviously meant something you get e.g. by using 'GoldMoney'. It's not a safety-desposit-box, I would certainly call it an 'account' and your money is not lent to other customers.
However, that said, I would disagree with Rothbard that there is something inherently fraudulent with fractional banking PROVIDED that the bank uses some option clause in case it doesn't have enough reserves. The Scottish banks did that (though for slightly different reasons), but if I remember correctly, the government forbade it because it was 'inconvenient'....

Costard - I don't see how the risks and the benefits accruing to the same individuals makes something fraud or not.
Take the case of the Mohammed cartoons, that, from memory, sparked off riots that killed people in countries far removed from the original cartoonist. The risks and benefits were definitely not accruing to the same individuals, but does that make what the cartoonist did fraudulent?

Or take the case of government paying for healthcare for children. Many adults support these schemes, around the world, even though they perfectly well know that they are at no risk themselves of ever suffering illness as a child again (their children might, but that's not them). You might think that these people are wrong to support government-funded healthcare for children, but I don't see how the governments that set up these schemes were being fraudulent just because the costs are imposed on people who don't directly benefit.

Also, how do deteriorating reserve standards create fraud? And loading costs onto taxpayers is perfectly doable without engaging in accounting games, when I worked for the NZ government its accounts were strictly kept, but the government did still take on a significant number of risks (eg insuring travelling art exhibitions, earthquake insurance, etc), all properly documented. Might not be a good idea, but I don't think that everything that isn't a good idea is therefore fraudulent.

Once someone commits to the position, it's no use arguing. They'll just keep saying that two people can't have the property right, even if you were to state what the bank is doing in big letters on every bill and bank document.

I agree, the Rothbardian stance is just plain weird. There's always a chance the money is not there, arguing about semantics is meaningless. People can change their account type or sue their banks, its not others' business to intervene, atleast from Austrian point of view.

But I think Rothbard was right on the nail on the history of banking. Our banking would definitely be totally different under free banking. It would likely be some commodity money and bank runs (without bailouts) would probably push up higher reserve ratios. The way governments have monopolized money (making) and banking could definitely be one of the major reasons for many macroeconomic problems.

@jiriki - if one can judge from the scottish experience (and if I understand it correctly), free banking had pretty low reserves at that time. However, they had very high percentage of capital (15-30%), which I think is rather uncommon these days.

Rothbardians believe that FRB leads to a boom/bust cycle, and therefore is economically destructive.

At the same time, Rothbardians believe that the only basis for banning a transaction is that it involves force or fraud. If FRB isn't fraudulent, then Rothbardians are stuck in the position of saying that FRB will destroy the economy even in a perfectly free market system, and that there is nothing you can do about it.

Given that tension, it is not surprising that Rothbardians have tried to claim that FRB is inherently fraudulent and thus may be banned, weak as those arguments may be.

The idea that fractional banking is immoral didn't come from Rothbard. He merely passed it on. Jesus Huerta de Soto gives us the history of the debate in his book "Money, Bank Credit, and Economic Cycles."

Bryan, if you are interested in understanding banks and financial systems in general, I suggest to rely on the functional perspective on financial systems that Bodie, Merton and others have been trying to develop, starting with

As long as no one is forced to bail out a depositor in an FRB system, then I would agree that FRB need not be considered a fraud. I tend to agree with Blackadder above that Rothbardians have probably stuck themselves with a weak argument because they believe FRB to be economically harmful, which is a bit ironic considering their other stances on personal liberty.

Now, my first condition is a pretty harsh one, and I think it can be clearly shown that people are being forced to bail out FRB customers and owners. So a fraud is being perpetrated today, even if it is entirely legal.

You think the average person understands how banking works? Surely you have taught classes that should have disabused you of this notion. The proverbial Man In The Street hasn't got a clue.

When you deposit money in a bank, the bank tells you the money is still yours and you can withdraw it at any time. Under fractional reserve this is a lie, period.

Note that under a minimally modified system where it is made explicit that your deposited funds are NOT yours and NOT necessarily available for withdrawal at any time, bank runs are impossible. The bank simply tells you "your" money can't be un-deposited right now and you can take a hike, or possibly avail yourself of some limited withdrawal rights or whatever is specified in the account contract. Customers get angry but the bank isn't insolvent.

"Rothbardians believe that FRB leads to a boom/bust cycle, and therefore is economically destructive.

At the same time, Rothbardians believe that the only basis for banning a transaction is that it involves force or fraud. If FRB isn't fraudulent, then Rothbardians are stuck in the position of saying that FRB will destroy the economy even in a perfectly free market system, and that there is nothing you can do about it.

Given that tension, it is not surprising that Rothbardians have tried to claim that FRB is inherently fraudulent and thus may be banned, weak as those arguments may be."

This is spot on, this is one of my main factors from moving away from Rothbard when it comes to money and banking. The inconsistency is so large and in-your-face, I'm amazed that more people have not spotted it yet.

Once someone commits to the position, it's no use arguing. They'll just keep saying that two people can't have the property right, even if you were to state what the bank is doing in big letters on every bill and bank document.

Statements like these simply demonstrate that most people don't even bother to define fraud before they start.

Promising something that cannot be delivered is one of the simpliest definitions of fraud possible. Consider an advertisement seeking investors for "faster than light travel" opportunity. If the person seeking investments knows- or believes- that faster than light travel is impossible he is committing fraud! That is true even if he is very up front about the fact that he is seeking to create faster than light travel.

The difference between what banks do and faster than light travel is that banks do in fact do what they promise millions of times each day. So clearly it is possible (it's not guaranteed, but nothing in life is).

Tracy - I will not be crucified upon this cross of fraud! Rothbard is the one who said it, so if you want to parse the meaning of the word as understood by him, I suggest you exhume his corpse and find some defibrillators. My argument vis a vis the risks and benefits was made only upon the pretext of whether or not modern FRB is a "good idea".

Blackadder, Michael - Why on earth would one need to establish that FRB is fraudulent, merely to argue for the removal of laws that mandate its existence? We're not talking about private transactions but public policy. Did Rothbard say that the existence of a bank in Iowa without 100% reserves will "destroy the economy"? Or did he say that modern FRB - government backed and under the auspices of a central bank - will do so? Maybe some Austrians, inconceivably, fit the mold you have made for them. But so what?

History is painfully clear that, to the extent banks are free, higher reserve ratios are forced upon them. If bank runs are allowed to happen, and banks are allowed to fail, the incentives fall where they should: it is in the interests of bankers and depositors to exercise caution. In the event that banks are every truly free - and we'll have to imagine this, because nobody's ever seen it, and certainly the banks have never wanted it - we might find out, once and for all, what existence fractional reserve has in an Austrian society.

At that time a debate over the definitions and sub-definitions of "fraud" may become relevant, or at least not so intolerably cute.

The difference between what banks do and faster than light travel is that banks do in fact do what they promise millions of times each day. So clearly it is possible (it's not guaranteed, but nothing in life is).

If I want to stretch the analogy that would be like saying "I have traveled 5 mph, 100 mph, even 500 mph- therefore I am not committing fraud since I have fufilled a portion of my pledge"

The issue Rothbard brings up with Fractional Reserve Banking is that the bank makes 1,000 promises when it can only keep 100 of them at any one time. When people lined up outside banks to withdraw their money at the beginning of the great depression the banks reniged (sp?) on their promise to return their cash "on demand". Remember that the FRB system they operated under meant that if, at any time and without regard to the reason, X number of people had shown up requesting their money there was a number that could be reached which the bank could never fufill their promise to- and that number was always fewer than the total number of promises that they made.

fundamentalist, Troy, deposits do not fund loans in modern banking. Ask anyone who does accounting for a bank. When you sign a piece of paper that says you will pay $X a month for Y months you have created a piece of paper with value i.e. money. The bank only needs to cover the difference in how much the loan is worth in today's dollars vs future dollars. A $100 loan obligation isn't worth $100 right now because of inflation and the risk of default. Those discounts are gauged by the interbank loan market prices. Of course you can't have a real price until you actually sell. So when a bunch of banks try to sell loans at once because of a shortfall the market price for loans drops and the banks are left with "toxic assets".

The crisis was caused by the artificially high paper price of 30 year loans. Hardly anyone actually wants money with that long a "not good until" date. As long as no one was selling significant amounts the paper price could remain in fantasy land.

I would say this is the same argument that says "if the customer is aware of it then it is not fraud".

My claim is that under the legal principal as per de soto's book Money, Credit, and Economic Cycles chapter 3. It is fraudulent to enter into a contract that you (before the event) knowingly can't meet, i.e. agreeing to an ‘on demand’ clause when in fact it is lent out. Putting funds at risk via loans that are held ‘on demand’ breaches the ability of the lender to meet the 'on demand' function as per the agreement. Remove the 'on demand' clause and this then transforms the ‘on demand’ agreement into a time deposit.

Now I would concede that perhaps it is not fraud under the current system as we have a central bank which uses non-free market activities to provide a privilege to the banking industry. The banks can then point to this fact and argue that they can indeed meet the ‘on demand’ clause per the contract.

It is fraudulent to enter into a contract that you (before the event) knowingly can't meet, i.e. agreeing to an ‘on demand’ clause when in fact it is lent out. Putting funds at risk via loans that are held ‘on demand’ breaches the ability of the lender to meet the 'on demand' function as per the agreement.

How so? Loans are assets owned by the bank, and if an unexpected need for cash to repay deposits arises the bank can borrow against (or sell) the loans in the interbank market in a matter of hours to get the cash. That's the normal course of affairs. (In the worst case it can do the same via the Fed.) A solvent bank will always be able to cover 100% of deposits by this route.

So how does this become a situation where 'before the event they knowingly can't meet' their repayment obligation?

ISTM the anti-FRBers aren't really anti-FRB at all, but anti-mismatched maturities, borrowing short to lend long.

Take a finance company that borrows at 30-days in the financial paper market to lend at higher rates via multi-year auto loans or whatever. "It csn't possibly pay off all its 30-day paper when it matures as promised because the money has been loaned out for years -- it doesn't have the money." (And let's not pretend a run can't happen in the money market or on a company's paper.)

Is this not the exact same "fraud", with the exact same result? Promising to repay money soon at a specific date when you knowingly won't have it because you've loaned it long? Yet such a finance company is not a bank and this is not fractional reserve banking.

Of course, the finance company *can* repay all its 30-day paper even if a run on it occurs by borrowing against or selling its loan assets -- just like a bank.

Now if either the finance company or bank becomes insolvent due to bad management or bad investments it might not be able to pay its short-term creditors -- but that's true of any business, say "General Motors".

The systematic financial risk with borrowing short to lend long is that there might be a run on the short obligations at a time when the long ones are depressed in value.

But as we recently saw, mismatched maturities are *hardly* contstrained to fractional reserve banking. The whole financial system is built on it. If the Rothbardians are opposed to it they should just come out and say so -- their fixation on bank deposits is bizarrely near-sided.

And without mismatched maturities, well, the wait for enough people buy 4-yr CDs to get a 4-yr car loan could last a while.

Please note that I did say, "Most people I know mistakenly assume that that is where the modern bank gets all of its money to loan out." Why do you suppose I said that?

At the same time, there is a reason why savings accounts pay a lower rate than people have to pay back in loans. The difference is what the bank earns. It's mostly a holdover from when banks were not backed by the Fed's loans.

You ask: Why on earth would one need to establish that FRB is fraudulent, merely to argue for the removal of laws that mandate its existence?

There are no laws prohibiting a bank from holding 100% reserves (and in fact many banks do allow you to do this by opening a safety deposit box). There are minimum reserve requirements, for example, but no maximum reserve requirements.

If you talk to the Rothbardians, they will tell you that they do not simply want to make it legal for a bank to hold 100% reserves; they want to make it mandatory.

You say: The issue Rothbard brings up with Fractional Reserve Banking is that the bank makes 1,000 promises when it can only keep 100 of them at any one time.

Not true. Suppose a local ice cream shop promises to give me free ice cream for a week on demand. On Tuesday I do not demand any ice cream. Has the ice cream shop kept it's promise to me? Certainly. The promise was that if I demand ice cream, I will be given it. That hasn't been violated.

Similarly, if a bank promises to give money to 1,000 people and only 100 show up to claim it, the bank has kept its promise to the 900 who don't show up just as much as to the 100 that do.

If I promise you 1 scoop of ice cream at any time you want but I have no ice cream to deliver give you then I have defrauded you at the time of promising the ice cream. The fraud is not committed when you demand the ice cream- that is simply when the fraud is discovered, the fraud is committed when I promise you something that I knowingly cannot supply.

If I promise 1 scoop to 2 people but I only have 1 scoop then I have commmited fraud because I cannot hope to meet both obligations.

Lets say that a bank took $10 from 10 people and promised each of them on demand withdrawl. The CEO of the bank then stole $90 and spent it on drugs and candy- clearly the CEO has committed fraud in this case. Did the CEO commit fraud when he took the money or did he commit fraud when the 2nd person asked for his money back?

Furthermore if the CEO then took a 2nd job and used that money to refund the deposits and he lucks out and only 1 person asks for a withdrawal before he can earn enough- would you claim the CEO never committed fraud simply because he wasn't caught?

If I promise you 1 scoop of ice cream at any time you want but I have no ice cream to deliver give you then I have defrauded you at the time of promising the ice cream.

If you know you aren't going to have ice cream when I come in and ask for it then that's fraud. On the other hand, if you expect to have ice cream to give me when I come in, then that's not fraud, even if you are aware of the possibility that there could be a really busy day when I come in such that you're out of ice cream.

By your logic, pretty much all gift certificates would be fraudulent, since it's not as if when I buy a $20 gift certificate for Ben and Jerry's they put $20 worth of Chunky Monkey in a freezer somewhere as "reserves."

Lets say that a bank took $10 from 10 people and promised each of them on demand withdrawl. The CEO of the bank then stole $90 and spent it on drugs and candy- clearly the CEO has committed fraud in this case. Did the CEO commit fraud when he took the money or did he commit fraud when the 2nd person asked for his money back?

In your example the guy has stolen money from the bank, so obviously the crime occurs when he took the money from the bank, not when the bank took the money from the depositors. If the guy had gone to each of the ten depositors and said to them "please lend me $10, I promise I'll pay you back whenever you want; I am going to use the money to buy drugs and candy" and they still gave him the $10 then that wouldn't be fraud.

By your logic, pretty much all gift certificates would be fraudulent, since it's not as if when I buy a $20 gift certificate for Ben and Jerry's they put $20 worth of Chunky Monkey in a freezer somewhere as "reserves."

No, it would only be fraudulant if they knowingly sold more gift cards than they could redeem.

If you know you aren't going to have ice cream when I come in and ask for it then that's fraud. On the other hand, if you expect to have ice cream to give me when I come in, then that's not fraud, even if you are aware of the possibility that there could be a really busy day when I come in such that you're out of ice cream.

Actually this is, by definition, fraud. If you promise something 100% that you know in reality is only 90% you have committed textbook fraud.

Here is the big difference between all the scenarios you propose and FRB. In FRB the bank explicitly makes a certain # of promises when it knows 100% that it cannot honor them all at the same time. The fact that they are counting on people not finding out is of no importance to distinguising fraud or not fraud.

"please lend me $10, I promise I'll pay you back whenever you want; I am going to use the money to buy drugs and candy" and they still gave him the $10 then that wouldn't be fraud.

Actually you are wrong as this is clearly fraudulant. If you asked for your 10$ back 1 min after he finished the candy and drugs you would be within your rights to sue for breach of contract when he couldn't pay.

There is a big difference between "I promise to pay you as soon as I can" and "I promise to pay you at your discretion".

There is no relevance to the statement "I am going to use the money on X" only on the section "I will pay you back on your timeline".

Caplan has addressed one of the biggest issues i have with Rothbardian libertarians- that they want to make 100% reserve banking with a gold standard mandatory, which is pure coercion, and goes against everything libertarianism stands for. to justify this stance without admitting they are forcing their values on others, they desperately try to make FRB out to be fraud. with free banking, the reserve ratios would undoubtedly be much higher than 10% in order to avoid bank runs. but banks would be competing for deposits by offering higher interest rates. how exactly can a 100% reserve bank compete with, say, a 75% reserve bank? people are always chasing higher returns. the supposed "safety" of a 100% reserve bank does not make a difference to depositors if every other non-full reserve bank is offering interest rates several hundred basis points higher than they can. whatever the natural reserve ratio the market will reach equilibrium at, it will assuredly be lower than 100%. thus, it is irony for them to claim FRB only persists because of government coercion when the truth of the matter is that full reserve banking can only exist if forced upon banks through arbitrary laws.

not to mention this obsession with a gold standard. why should banks be forced to use gold? there are other precious metals that meet the requirements of being homogeneous, durable, portable, and fungible (silver, platinum, and palladium). and there are non-precious metals like aluminum, copper, iron, lead, nickel, zinc, etc. there would be exchange rates between banknotes backed by different metals. there is no reason to force banks to use gold and only gold.

the whole thing is just obnoxious really. personally, i think libertarians who defend Rothbard on this matter are those who just dont want to admit the man was wrong about something. very similar to the way some libertarians defend intellectual property laws only because Ayn Rand supported them.

If everyone asked to take out the money out of their checking accounts the banks would be insolvent because it would run out of money. That is fraud. To pretend that it isn't is ridiculous.

And Rothbard never said that it would not be fraud to sell ordinary bread when the contract specifically stated organic bread. He was big on contracts and would not look kindly to those that did not meet the conditions specified in those contracts.

You write: Here is the big difference between all the scenarios you propose and FRB. In FRB the bank explicitly makes a certain # of promises when it knows 100% that it cannot honor them all at the same time. The fact that they are counting on people not finding out is of no importance to distinguising fraud or not fraud.

No, this is also true of my other examples. Take Starbucks gift cards, for example. Starbucks knows with 100% certainly that if everyone who holds a gift card shows up at the same store on the same day, they will not be able to honor them. The same is true for every other sort of gift card. So if that's fraud (which it is not), then gift cards are of their nature fraudulent.

You also say that if a guy says to me "please lend me $10, I promise I'll pay you back whenever you want; I am going to use the money to buy drugs and candy" and I agree he has still committed fraud because If you asked for your 10$ back 1 min after he finished the candy and drugs you would be within your rights to sue for breach of contract when he couldn't pay.

It's true that *if* I asked for the money back and he couldn't pay, *then* he would be in breach of contract. But he wouldn't be in breach *until* that happened, and there wouldn't be fraud involved in any case, since I knew what he was going to do with the money (not all breaches of contract have to involve fraud), after all).

If I promise you 1 scoop of ice cream at any time you want but I have no ice cream to deliver give you then I have defrauded you at the time of promising the ice cream. The fraud is not committed when you demand the ice cream- that is simply when the fraud is discovered, the fraud is committed when I promise you something that I knowingly cannot supply.

OK Tom, under the parameters you're using here, that would indeed be fraud. The problem with your broader argument is that this is not how modern or any other kind of FRB works. Fraud, in common law jurisdictions, is about intentional misrepresentation for personal gain. If I misrepresent the facts (for instance, by telling you that I will always have enough ice cream to meet your demands, under any circumstances and at all times) with the intention of misleading you into making a decision you would not otherwise make, I'm committing fraud.

But no bank does this. Modern FR banks promise to have cash to meet your demands and they fully intend to actually have that cash on hand when you arrive to demand it: Otherwise they would happily run their reserves down to zero and then abscond with the profits. That lack of intention is key to deciding whether a particular case involves fraud or not. If I'm a home salesman and I make some promises to you about the house I'm selling, but some neighborhood kid comes and burns the house down between the time when I make those promises and the time when you would take possession of the house, I'm not committing fraud because my misrepresentation of the future state of the house was not intentional.

I think blackadder is correct. There's an essential tension between the position that the state shouldn't interfere with the market except to punish the unlawful use of force and fraud and the belief that fractional reserve banking causes the business cycle, which causes people who have this cognitive dissonance to try and resolve it by seeing fraud into a transaction where there isn't any. Combine that with the age-old knee-jerk mistrust of money changers and bankers, and you've got a recipe for a whole lot of populist anger.

Milton Friedman favored a 100 percent reserve requirement, but his reason was very different.

Friedman noted that, historically, credit markets often experienced booms and busts. In a fractional reserve system, the money supply grows in credit booms and contracts in busts. This spillover amplifies the effect of credit market instability on the economy. A 100 percent reserve requirement insulates the money supply from credit-induced variations and hence increases the stability of the economy.

I believe the point that Rothbard is trying to get across, is that in having fractional reserve banking, banks increase lending and excessive consumption results. When credit is made more readily available through lower interest rates people are more frivolous in their spending. Banks are lending to unqualified borrowers and government monetary programs such as the FDIC backing of deposits increase this risk. Furthermore, banks are taking on more risk in leading than they otherwise would without such system in place. The reason this constitutes fraudulent activity from his point of view has to do with others spending money that does not “belong” to them, as it is actually another person’s deposit that has been lent to an individual. The fraudulent aspect of this arises during a liquidity crisis when a bank encounters issues of insolvency. He is stating that in not having 100% backed currency is fraudulent because the individuals that make their deposits are at risk of not getting them back. In other words the bank makes loans with a high risk, high reward scenario and the bank takes the reward but passes the risk on to the depositors. The real person inheriting the risk of the barrower not paying back the loan is the original depositor who would not receive his deposit back in time of crisis. Take for example the collapse of the recent housing bubble that lead to the economic recession after the repeal of Glass Steagall Act.

Let us suppose the the Federal Reserve was abolished as Mr. Paul has proposed, and that banks are required to hold 100% of deposits in reserve, also as proposed by Mr. Paul. What are some practical implications of such a system?

The money is hers (in a 100% reserve system), and cannot be lent to another person, barring some time limits on when she can again withdraw the funds. IE: a certificate of deposit.

HerBank, in order to lend funds to anyone (Mr. Smith for instance), must own the funds it intends to lend, or have rights (those funds cannot be withdrawn by the depositor during the time it will be vacated by the loan) to the funds. In this case, there are actually three owners of the same money, The depositor, the bank, and the debtor, who borrows the funds.

Now let's supposed that Mrs. Jones did deposit into a Certificate of Deposit, but decides she needs the money back, and is willing to pay an early withdrawal penalty. The bank, in good faith lent the money for a duration not exceeding the time limit imposed by the CD, and no longer has the funds (her funds), with which to pay her back. That is, at least, not without violating it's 100% reserve requirement.

Mr. Smith would like to buy a house valued at $250,000.00 Where does he get a loan? How in the world does anyone get a loan?

Where does a loan come from that is NOT secured by a tangible asset? A business loan for example?
What happens when the bank loans money secured by a tangible asset, but that asset, (a house for instance) is not liquid, and cannot be rapidly liquidated in order to meet any demands for with-drawl by depositors?

Who has thought this Ron Paul Abolish the Fed thing through? Help me understand how it would work, I'm willing to learn.

Blogging software: Powered by Movable Type 4.2.1.
Pictures courtesy of the authors.
All opinions expressed on EconLog reflect those of the author or individual commenters, and do
not necessarily represent the views or positions of the Library of
Economics and Liberty (Econlib) website or its owner, Liberty Fund,
Inc.

The cuneiform inscription in the Liberty Fund logo is the
earliest-known written appearance of the word
"freedom" (amagi), or "liberty." It
is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.